New Credit Scoring Models Benefit Consumers, Businesses

With all the attention given to credit scores - what they are, where to find them and how they are used - it might come as a surprise to learn that many Americans might not even have one. According to the Consumer Financial Protection Bureau, as many as 1 in 10 U.S. residents - around 45 million people - have no useful credit history at all. Without this information, successfully applying for a credit card, a business loan or a mortgage becomes difficult if not impossible.

To better understand why so many consumers are left out of the traditional credit landscape, the CFPB began a new initiative that will use significantly more data to determine credit histories. Following the Bureau's lead are many financial institutions, credit monitoring agencies and other businesses that are developing new ways to bring these people into the fold.

Why some are left out of credit

The way in which credit scores are tabulated hasn't changed significantly for several years. According to Credit Karma, most agencies use the same standard information  and formulas to determine a person's creditworthiness as quantified by a number. The biggest factors, from most important to least important, are:

• Credit utilization: The amount of credit being used as a percentage of one's total open credit line.
• Percentage of on-time payments.
• Number of derogatory marks: These include any collections activity, bankruptcy, foreclosures or liens recorded in the last several years.
• Average age of open credit lines.
• Total number of open accounts: Including credit cards and other loans.
• Total hard credit inquiries: A hard inquiry is made by a lender prior to extending a major loan like a mortgage or student debt.

Together, these factors create a fairly comprehensive picture of a person's financial history. But they still may allow others to slip through the cracks. For example, someone who has never had a credit card would have no record for most of these factors. Earning significant income through cash, having few assets like a car or house, and many other situations make some people essentially invisible to credit agencies.

Without being able to apply for basic forms of credit, consumers who lack any credit history will find themselves stuck in a cycle of difficulty as they look for ways to finance a home purchase, open a car loan or even apply for an apartment lease.

"People with little or no credit history, or who lack a credit score, have fewer opportunities to borrow money in order to build a future, and any credit that is available usually costs more," CFPB director Richard Cordray said in a statement . But "There's a lot more data out there that consumers don't get credit for." Cordray and others believe that lenders would be more willing to extend credit to more people "if alternative data suggest that a particular consumer with such a score would be less likely to default on the loan."

With that goal in mind, credit agencies and lenders are developing new models that could expand the number of consumers able to successfully apply for a loan or pass a basic credit check. Some of the data that lenders might now utilize when developing an individual's score include:

• Rent payments.
• Mobile phone service contract records.
• Cable TV and internet payments.
• Bank account information regarding deposits, withdrawals and transfers.

Some of these factors are already being used when determining credit scores for certain products and services. The CFPB noted that this list could grow as data collection becomes easier, and could include personal information sourced from social media accounts or internet use.

Pros and cons of alternative data

The CFPB and others have explained that collecting and using alternative forms of financial data to assess creditworthiness comes with several benefits as well as drawbacks. Among the positive developments expected from these initiatives are:

• More accurate and comprehensive credit history data for everyone, which could improve credit scores for some borrowers.
• Faster implementation of credit changes so that updates come in real-time.
• Higher levels of service for credit users.
• Lower costs for lenders.

The potential pitfalls of these new sources of data and scoring methods include:

• Increased potential for errors or incomplete records.
• Added difficulty for those looking to actively change their score.
• Unintended consequences such as encouraging behavior that could improve scores.
• Increased potential for discrimination in financial reporting and credit scoring.

Whether or not these problems outweigh the benefits is difficult to determine, but in any case, credit consumers can expect to see some changes to their scores relatively soon.